The central theme of this book is that a macroeconomic policymaker's role is to enhance the public's ability to coordinate its information, expectations, and economic activities. We narrow the focus of information coordination to policymaker efforts to minimize public uncertainty about current and future inflation. If policymakers take actions to attain a specific inflation rate – and consistently achieve this target – then the public will learn to incorporate this value as its inflation expectation. At the macroeconomic level, we argue that this added certainty in future inflation aids in the stability of future plans and, ultimately, leads to what we have called IOCS.

The findings are wide ranging. In Part I, starting with Chapter 2, we used basic statistical analysis to illustrate the macroeconomic stability and instability in the United States since 1960. We find that both inflation and output stability (IOCS) coexisted for a significant part of this 41-year period.

In particular, IOCS occurred (roughly speaking) for the periods 1962–9 and 1985–2000, periods that coincided with the longest economic expansions since 1854. Furthermore, because IOCS depends on the coordination of price information, we also examine the ability of the public to make and learn correct inflation forecasts. We find that increasing inflation forecast accuracy coincided with periods of IOCS.

Another issue in Chapter 2 is to illustrate whether key policy indicators share periodic patterns that coincide with periods of IOCS.

The theory of economic policy occupies a central place in academia and government. This book addresses concerns in both communities. For academics, this book examines the ongoing scientific endeavor to determine the most accurate role for policymakers is in stabilizing it. Scientific controversies center on such issues as the relation between inflation and real outcomes and how these disagreements influence the supposed effectiveness of policy. In more technical language, a particular scientific controversy of interest to us is the evolution in thinking about the slope of the Phillips curve and how this has influenced policy and outcomes (see Akerlof et al. 2000).

The central theme of this book is that a macroeconomic policymaker's role is to conduct policy in such a way as to enhance the public's ability to coordinate its information, expectations, and economic activities. Our view is that policy actions that facilitate the public's coordination capability are essential for ensuring a stable and predictable framework for the rules that govern social and economic interaction. When policymakers encourage coordination, one of the primary consequences is efficient macroeconomic outcomes, the full employment of resources with price stability.

There are several ideas, some prescriptive, some purely academic, that provide a foundation for this theme. First is the necessity for coordination. We use the term coordination to define the actions a person or persons take to interpret and order streams of information (primarily political and economic) and to use that information in making their economic plans.

A second idea is that coordination involves strategic interaction between policymakers and the public. This interaction can be conflictual.

If we consider U.S. IOCS performance in the last 40-plus years and classify this period according to inflation-stabilizing policy stances, a few facts emerge. Between 1960 and 2000, policy practices that emphasize and deemphasize inflation stability coincide with distinct IOCS and non-IOCS behavior. Among the more dramatic business cycle episodes was the stagflation of the 1970s, the sharp disinflation of the early 1980s, and the expansions of the 1980s and 1990s.

To gain a deeper understanding of the relation between policy and IOCS, we discuss these patterns in the context of various historical events (see, for example, Mayer 1999; Taylor 1999a; Orphanides 2003). These events precipitated various policy reactions, which in turn had important economic outcomes. These economic outcomes are associated with the emphasis and deemphasis placed on inflation-stabilizing policy actions (Clarida et al. 2000).

In this chapter we also demonstrate that the variability in policy (and IOCS) was not haphazard, but stemmed from changes in scientific research concerning the Phillips curve. Recall that our view is that academic ideas and policy implementation should be blurred. Indeed, both academic and policymaker attitudes toward the Phillips curve best illustrate whether policymakers are going to act in ways that facilitate information coordination.

Indeed, we do find that policy implementation deemphasized and then reemphasized inflation stability as academic views on the Phillps curve evolved.

This chapter solves the theoretical model in Chapter 4 and demonstrates the effects of the Taylor rule (adherence to the Taylor principle) on output and inflation stability. Our dynamic equilibrium model uses the interaction of policy (transmitted via interest rate movements) with temporary information coordination rigidities. A particular focus is on trade-offs between inflation and output volatility and on whether IOCS can exist. We also determine the possible trade-offs posed by various policy targets (hereafter termed crossover effects).

We evaluate the model outlined in Chapter 4 by conventional means. As McCallum (2001b) notes, standard evaluation practice occurs along the following lines:

Feasibility

In this section we first determine whether policymakers can reach their desired levels (targets) in inflation and output. This step is basic for any further inquiry.

Part I of this book provided some data, basic statistical analysis, and a focused historical account to highlight the link between inflation-stabilizing policy (related to the Taylor principle) and IOCS. We also showed a trade-off between interest rate volatility and IOCS. Still, the prior analyses are correlations between economic activity and policy instruments. We know these patterns are not the same as specifying a model that can identify causal relations between inflation-stabilizing policy and IOCS.

In this chapter, and for all of Part II, we characterize monetary policy so that we can infer both the policymaker's objectives and strategy. In subsequent chapters, we solve this model in order to demonstrate a behavioral relation that links policy instrument response to changes (variability) in inflation and output. Here, we describe (but do not yet solve) a structural model that shows the aggregate consequences of policymakers who promote information coordination. Following convention, we use a simplified three-equation representation that includes a supply function, an IS function, and a Taylor rule (see Rotemberg and Woodford 1997, 1998; Romer 2000; and McCallum 2001b).

Price Level Adjustment

The aggregate supply function we use incorporates a natural rate constraint and is a standard lagged expectations, augmented Phillips curve. There are variants of this model that apply to information signaling (Lucas 1972, 1973), institutional rigidities (Gray 1976, 1978; Brunner et al. 1980, 1983), and two-period nominal or real contracts (Fischer 1977; Taylor 1979, 1980; Fuhrer and Moore 1995a, b).

A central concept in this book is the simultaneous decline in inflation and output volatility – inflation-output costabilization (IOCS). Many researchers have documented the decline in economic volatility in the United States and elsewhere (Kim and Nelson 1999; McConnell and Perez-Quiros 2000; Blanchard and Simon 2001; Kahn, McConnell, and Perez-Quiros 2001, 2002; Labhard 2003; Martin and Rowthorn 2004). Much of this work focuses on output stability. One consistent finding is that this work dates the decline in volatility to the 1980s.

In this chapter we extend this research in several ways. Our purpose is to illustrate the economic stability in the United States since the 1980s and lay the groundwork for the relation between IOCS and policy. We explore this linkage in the following manner. First, we investigate the behavior of economic data. In particular, we examine together (and then separately) the volatility of inflation and output. Our particular concern, of course, is IOCS – the simultaneous and sustained reduction of both inflation and output volatility. In addition, to see if periods of inflation and output stability occur prior to the 1980s, our analysis covers the period 1960–2000.

In Part II, our focus was on developing a small-scale macroeconomic model that captured policy effects. We focused particular attention on how a policy emphasis on stabilizing inflation (adherence to the Taylor principle) could, under certain conditions, attain IOCS. The macroeconomic results presume coordination dynamics of a particular kind between policymakers and the public. These coordination dynamics between policymakers and the public center on the stream of information transmitted by price and on how policymakers could reduce the public's uncertainty about future inflation.

The threat posed by inflation is the noise it brings to bear on the price signals that the public uses when making forecasts and plans (see Friedman 1963, 1977). We know the noise exists, because there is a (positive) theoretical and empirical relation between inflation variability and the mean of inflation (see Vining and Elwertowski 1976; Parks 1978; Cukierman and Wachtel 1979; Taylor 1981). As we have argued, a policymaker's role is to assist in coordinating the public's information by reducing the noise in price signals. We now turn our attention to how aggressive inflation-stabilizing policy (adherence to the Taylor principle) coordinates accurate inflation forecasts.

Policymakers coordinate price information for the public in the following way. When policymakers achieve and maintain inflation stability, the public can substitute what it thinks is an implicit or explicit inflation target (set by the policymaker) for past inflation. In this environment, plans (i.e., contracts) now exhibit (price) stability.